Q&A: What Is the Fiscal Cliff? (Updated)

Is the world going to end on Dec. 31? It would seem so judging by the heat generated by Washington’s wrangling over the budget. Here’s a WSJ guide to common questions about the “fiscal cliff” facing the U.S. economy. This is a revised version of the original postpublished earlier this year. You can read updates on the Fiscal Cliff at wsj.com/FiscalCliff, and follow on Twitter at @wsjfiscalcliff.

What is the “fiscal cliff”?

The fiscal cliff is the phrase that’s become associated with the combination of $500 billion in spending cuts and tax increases that are scheduled to automatically start at the start of 2013.

Why are we facing a cliff at all?

Think of the past two years as a rolling series of arguments about taxes and spending, none of which have been brought to a satisfactory conclusion. One of the fiercest standoffs happened in the summer of 2011 over whether and how to raise the U.S.’s borrowing limit. The patchwork solution that raised the limit and prevented the U.S. from defaulting was to entrust a congressional committee with the job of crafting a big budget deal. Failure would lead to these across-the-board spending cuts and the natural end of the Bush-era tax code. The committee failed.

The Bush-era income-tax rates, which have been extended once already under President Barack Obama, will expire at the end of the year for all taxpayers. Also ending is a payroll-tax holiday, which means a tax increase for workers of as much as two percentage points. In addition, some 26 million additional people face the alternative minimum tax, or AMT, next filing season, which would raise their taxes liability sharply unless Congress acts. Other expirations include a variety of smaller tax cuts for both businesses and individuals collectively known as tax “extenders.” They include a tax credit for research and development and a deduction for sales taxes in states that don’t have an income tax.

And how about spending?

Across-the-board cuts in domestic and, particularly, defense spending would be triggered, including a $55 billion, 9% cut in the defense budget next year—that comes on top of sizable cuts already in the pipeline—and another $55 billion in cuts to domestic programs, including a 2% cut to Medicare providers.

What’s the economic impact of going over the cliff?

Pretty grim. If no agreement is reached to extend the tax cuts and block the spending curbs and they remain in place for more than a few weeks, the nonpartisan Congressional Budget Office projected the economy would contract 1.3% in the first six months of 2013, with the economy stabilizing in the second half and eventually achieving an annual growth rate of a whopping 0.5%. The agency didn’t provide new projections of the unemployment rate if the tax increases and spending cuts went into effect. Earlier this year, CBO estimated joblessness would rise to 9.2% at the end of 2013 if Congress didn’t act.

Some financial analysts argue the budget cutting that would automatically take place will eventually boost growth by putting the government on a firmer and more sustainable financial footing. The counter argument is that going over the cliff would cause a) investor panic and b) consumer panic and fundamentally derail what’s already a weak economic recovery.

Why are we arguing about this all over again?

Because a gridlocked Washington couldn’t solve the problem before the election, and because the election failed to provide much clarity by returning Mr. Obama to the White House and the GOP to the House majority. The fundamental divisions over how the country should tax and spend are real and heartfelt and won’t be easily overcome.

What are the biggest differences?

Taxes, specifically the top two tax brackets. Mr. Obama campaigned and won on a promise to keep most of the Bush rates the same for everyone except the highest-income Americans. He argued they should “pay their fair share” to help restore the budget. Republicans have pledged to not let that happen, contending such a move would hurt small-business owners who pay taxes through the individual-tax system. Also, the GOP for a generation has pushed for lower rates across the board as a matter of principle.

Thus far, Republicans have offered about $800 billion in new tax revenue by limiting deductions taxpayers can take for things like mortgage-interest payments and charitable donations. Mr. Obama wants that plus the $1 trillion or so that would come from raising top rates on income and investment taxes. Between those two numbers is where the sides would likely have to meet to get a deal.

It’s really all about taxes?

No. Revamping—or not, as the case may be—America’s social safety net is an equally big cleavage. Democrats want to cut by tinkering, such as trimming payments to medical-service providers in the case of Medicare, although Mr. Obama has hinted he’s willing to go further. Republicans want to raise a lot more money through what lawmakers call “structural” or fundamental changes, such as increasing the retirement age or causing wealthier Americans to contribute more to the cost of their health care.

What’s the deadline for all this?

As the Journal’s Damian Paletta has written, there is a rolling series of deadlines. Congress really wants this wrapped up by Dec. 21, the likely date it plans to recess for Christmas. If that slips, we might be heading toward a smaller, band-aid-type fix.

What are the chances we go over the cliff?

No one knows. Everyone says it’s possible. Some think it likely. It’s hard to distinguish between posturing for a negotiating edge and what people really want.

And if there’s a deal, will we be done with this?

Sorry, no. Next year, assuming this isn’t all dealt with in some kind of omnibus solution, the U.S. will run out of borrowing room and will have to raise the debt ceiling again. Another bout could emerge in late March, when the government’s funding runs out.

And, don’t forget, even if there is a big deal that takes some of these questions off the table, the biggest and thorniest tasks (how to redo the tax code; how to tackle Medicare) will be deferred to 2013 under the two-step plan currently under consideration.

This makes me feel tired.

You might try to get used to it. We’re at the beginning of a demographic wave caused by the retirement of the Baby Boomers, and the costs of supporting them—in particular their health—will eventually dwarf the current budget deficits. Until our expected spending comes into line without expected tax revenue, these kinds of dustups are going to be a permanent feature of the landscape.

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